Entity Selection Vital for Start Ups

Christine Vann, CPA, MST, Alpern Rosenthal

The Pittsburgh market has seen a resurgence of start up companies as of late, many of which fall within the high tech sector.  Regardless of the type of industry, a new business has many challenging issues ranging from marketing to operations, but few may be more important than entity selection. There are many factors to consider for your business including ease of formation and operation, liability and tax consequences.  The choices for entities include: sole proprietorship, general partnership, limited partnership, limited liability company, C corporation and S corporation.

The first issue to address is ease of formation for the entity.  A sole proprietorship is the easiest to form. No legal documents need to be prepared and income is reported directly on the proprietor’s individual income tax returns. A partnership is also painless to create, as no documents are required to evidence a partnership. However, most advisors would recommend a written agreement. Formation of a corporation is more involved and expensive to organize and will likely result in legal fees in connection with the formation of the entity.  Registration is generally less complicated to form a limited liability company compared with a corporation.

Liability is one of the most important factors in choosing the type of entity for your business.  A sole proprietorship or general partnership does not provide protection from liability. If a business is involved in an activity that could result in liability issues, then it may be wise to consider a type of entity that provides limited liability to the owner(s).  Shareholders of corporations properly formed and operated are generally not personally liable for debts of the corporation.  Their financial exposure is generally limited to the amount invested.  Liability protection for a limited liability company varies by state.  A limited partner’s liability is usually limited to their investment in the partnership.  It is always advisable to discuss these types of issues with your attorney.

The type of entity will dictate how income and deductions are treated for tax purposes. Income from a sole proprietorship is taxed directly on the owner’s individual income tax return.  General partnerships, limited partnerships, limited liability companies and S corporations require separate tax returns to be filed for the entity, but the income and losses flow through to the individuals and are taxed on the income tax returns of the owners.  The income is taxed regardless of whether it is distributed or not.  Some business owners prefer a limited partnership or a limited liability company, which offer flexibility in allocating income and deductions. On the other hand, S corporations must allocate income and deductions based on stock ownership. C corporations could be subject to double taxation on income as the corporation pays tax on its income and shareholders and owners pay tax on dividends they receive from the corporation.

Choosing between a C corporation and an S corporation is an important decision for all start ups. If the business is expected to have losses in early years or has a high degree of risk, an S corporation may be preferable, as losses are deductible by the shareholders based on their percentage ownership. The deductibility of the losses is limited to the shareholder’s basis in the corporation. Basis is equivalent to one’s individual net investment in the company.  C corporations do not allow the deduction of operating losses by the individual stockholders and can only apply those losses to future income.  If fringe benefits are important, such as disability insurance and medical expenses, a C corporation may provide more flexibility than an S corporation as owners are generally treated as employees. 

Another item to consider is transferability of ownership.  A sole proprietor is not an entity separate from its owners, so a sale of the business is actually a sale of the assets.  Ownership of a corporation is easily transferred by selling the stock, although there may be an agreement between the shareholders restricting the transfer of stock.  Likewise, the operating agreement of a limited liability company or the agreement between partners of a partnership may restrict the transfer of ownership.

There are other factors to consider including, but not limited to, payroll considerations, capital stock or franchise taxes, the ease of governance, the number and types of owners and even the eventual disposition of the business.

As with any business plan, long-term goals need to be considered and entity selection is no different.  With the many alternatives available, sometimes the best choice of entity in your business plan is to form multiple entities in order to provide the best liability and tax benefits.  As one can see, there are several options that must be considered and each needs to be closely analyzed for success of you, your company and your business partners. 

Christine Vann, CPA, MST, is a Tax Shareholder with Alpern Rosenthal.  She can be reached at 412-281-6020 or at cvann@alpern.com

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